As a business owner, you are expected to file and pay your taxes each year. And the IRS knows there’s nothing wrong with trying to pay less in taxes, allowing you to use legitimate strategies to lower your tax burden. But there is a huge difference between using legal tax avoidance tactics and trying to illegally underpay. Understanding the difference between tax avoidance vs. tax evasion can ensure that you avoid committing tax fraud.
What Is Tax Avoidance?
Believe it or not, the IRS has a worksheet that outlines what constitutes legal tax avoidance vs. tax evasion. Essentially, tax avoidance involves using legal IRS programs to reduce your tax burden. It also means keeping accurate records so as to avoid overpaying on your taxes. There are a number of folks out there who pay more money each year than they have to because they don’t keep records of their earnings or because they misunderstand IRS tax codes.
Examples of Tax Avoidance
Federal and state tax codes allow for deductions, credits, and income adjustments that reduce your tax burden. Strategies include:
- Increasing your 401(k) or IRA contributions: Retirement savings are generally not taxed on their way into your retirement accounts (although there are limits on how much you can contribute per year). They are taxed on their way out. Before your total earnings for the pay period are calculated, the money is withheld and deposited into your retirement account. This decreases your overall tax burden.
- Work- or business-related deductions: Within reason, you can make specific deductions for your job. If you work from home, you can claim your office space as a work expense. Tools required for your trade are also deductible. When tax season comes by, you will have to determine if your work deductions exceed the standard deduction. If they do, then having a good accounting of your work deductions will save you money come tax time.
- Tax-smart college funds: If you’re setting up a college fund for your children, you may be able to take this money out of your income before it is taxed and reduce your overall tax burden.
- Home-equity deductions: Homeowners can write off improvements to their primary residence and interest payments on their tax returns.
- Health savings accounts: Some folks set up funds to help them pay for medical expenses. Things like retirement accounts and college funds are subtracted from your check before it is taxed.
What Is Tax Evasion?
When you avoid paying taxes by 1) failing to file at all, 2) hiding taxable income, or 3) fabricating deductions, the IRS can accuse you of tax evasion. In essence, the IRS will charge a taxpayer who avoids assessment or payment with tax evasion after conducting a thorough audit.
To prove tax evasion, the IRS must prove that you knowingly and willfully attempted to deceive the federal government. In other words, an honest mistake is not enough to charge you with tax evasion.
If you are trying to reduce a tax burden that you feel is either unfair or more than you can afford, knowing the difference between tax avoidance vs. tax evasion will help you ensure you don’t commit any illegal acts.
Examples of Tax Evasion
Essentially, if you provide any false or misleading information to the IRS or attempt to hide assets, the IRS can charge you with tax evasion, among other things:
- Underreporting income: If you lie about how much income you’re earning in order to reduce your tax burden, then you’re committing tax evasion.
- Fabricating deductions: One popular way to evade paying your taxes is to claim deductions of expenses that don’t exist. The IRS requires honest reporting of legitimate deductions.
- Failing to file a return: Another common way to avoid paying taxes is by simply failing to file a return. This is still considered tax evasion. You are expected to know that you are required to file taxes.
- Underpaying taxes: You are required to both file the tax returns and to pay the tax returns.
Additionally, businesses have an extra set of obligations and may be charged with tax evasion if they:
- Purposely understate payroll taxes;
- Neglect to withhold payroll taxes such as FICA;
- Hire an outside service to manage their payroll (which does not properly report withholdings to the IRS); or
- Pay employees “under the table” to avoid payroll tax obligations.
Punishments for tax evasion can be stiff. Fines between $250,000 and $500,000 are not uncommon, and neither are jail sentences.